Thursday, January 8, 2015

UPDATE: China does NOT follow US lead, taxing its global diaspora. (If they did, it would be a terrible idea).

This is an update of an earlier post. Earlier today I wrote that the NY times reported that China is embracing US-style citizenship-based taxation, by enforcing "a little-known and widely ignored regulation: Citizens and companies must pay domestic taxes on their entire worldwide incomes, not just on what they earn in China." The update is that this is entirely wrong, and that the NY Times just completely mangled this story by failing to understand the difference between defining income and defining residence (a distinction to which I alluded in my original post, below).

The reality is discussed at length by Eric over at Isaac Brock, who explains that "No, China does not have citizenship-based taxation." Eric's interpretation has been confirmed to me by a couple of people I know who are Chinese tax experts. So, I invite you to go there to read the full account, which I won't repeat here except to quote the takeaway, which is:

China as a country has many flaws and lacks many freedoms, but at least it uses the same basic system of taxation followed by nearly every democracy and dictatorship: a system which avoids placing unreasonable barriers in the way of the basic human right to leave a country.

Thanks to Eric and thanks to my colleagues who took the trouble to write me personally to correct the record. I hope that the Times acknowledges the errors and writes a new article on the subject to confirm that yes, the US is alone in its comprehensive treatment of non-residents as if resident solely on the basis of legal status as nationals.

In my earlier post I noted that last year when reviewing constitutional articulations of the taxing power, I noticed that China's constitution would suggest that its tax authority could have a global reach:

Article 56: It is the duty of citizens of the People's Republic of China to pay taxes in accordance with the law.

Accordingly, though it seems that China's constitution leaves open the possibility for China to follow the flawed US approach, it thankfully does not. The Times reported that the move would "[put] China on the same side as the United States in a global debate over whether taxation should be primarily national or global," and then says "On the other side of the issue are European nations, Japan, Australia and Canada, all of which tax people within their borders but exempt most expatriates and overseas subsidiaries from paying income taxes in their home countries."

This is not quite right. There is a global debate about taxing multinational companies on their worldwide (group) incomes, or not. However, there is no global debate about taxing individuals on the basis of their nationality. There is the United States, and then there is the rest of the world, with a very few and very limited number of exceptions (discussed below). If China were to align with the United States on this, it would be very big news not just for the global Chinese diaspora, but also for the ongoing OECD project on automatic exchange of information and for FATCA, because both regimes will struggle to implement the impossible demands of birthright tracing, which is necessary to enforce citizenship taxation.

The taxation of citizenship is about the definition of tax residence, rather than the definition of income. Many or perhaps most developed countries tax all individual residents, regardless of nationality, on their worldwide incomes. This makes sense because taxation is the pooling of resources for shared expenditures, and nationality and citizenship are irrelevant to this project. It would be absurd to only require citizens and nationals to pay for health care, schools, roads, police, courts, financial systems, etc, when the population using all of these goods and services includes noncitizens and nonnationals. Likewise, it is absurd to expect individuals to pay taxes in your country merely because your citizenship laws have conferred a legal status on them.

As a result, the OECD's AEoI project envisions a global system to identify the tax residence of every individual that owns virtually any financial asset, anywhere in the world, so that governments can assess their residents' tax obligations. The US project on FATCA goes further, requiring the global system to identify the nationality of every individual that owns virtually any financial asset, anywhere in the world. It won't be easy to build the OECD's residence identification database, but it is perhaps possible, with the help of tax treaties that resolve dual-residence problems. On the other hand, if the whole world gets into the business of nationality identification, we are going to have problems. This involves tracing bloodlines and will quickly become extraordinarily complicated, if not impossible, as we have already seen with FATCA.

Every income tax system necessarily has extensive residence assignment rules, including the United States; it is just that the United States also includes nationality in its definition, while almost every other country does not. The United States does this even if such persons achieved US nationality through the accident of birth, even if they never stepped foot in the United States and have never used any US goods or services of any kind, even if they are also citizens and permanent residents of other countries from their birth, even if they have never has a social security number or a US passport, even if they do not know that that they are US nationals, and even though the claiming of persons as subjects by birth by a distant sovereign was the foundation for America's war for independence.

All other nation-states tax on the basis of residence, not nationality, with a few minor and limited exceptions. Here they are:

Eritrea taxes nonresident citizens permanently, at a reduced flat rate of 2% of worldwide income. It does this to finance an ongoing war, and had been denounced by the United States and the UN for the practice.

Finland treats nonresident citizens as tax resident for three years after the emigrate unless they demonstrate that they no longer have any ties to Finland.

France treats nonresident citizens as permanent tax residents if they move from France to Monaco, per a treaty between the two nations.

Hungary treats nonresident citizens as permanent tax residents of Hungary, unless they also have another nationality or reside in a country which has a tax treaty with Hungary.

Italy treats nonresident citizens as permanent tax residents if they move to a blacklisted tax haven unless they demonstrate lack of ties to Italy.

Spain treats nonresident citizens as tax residents for five years following a move to a blacklisted tax haven.

Turkey treats nonresident citizens as permanent tax residents if they work for the Turkish government or Turkish companies but exempts income that is taxed by the country where it is earned.

Some countries used to but no longer practice citizenship-based taxation:

Bulgaria used to treat nonresident citizens as permanent tax residents, but ended the practice with the adoption of a new income tax in 1998.

Mexico used to treat nonresident citizens as permanent tax residents, but ended the practice with the adoption of a new income tax law in 1981.

Myanmar used to tax the foreign income of nonresident citizens at a flat rate of 10% but ended the practice in 2012.

The Philippines used to tax the foreign income of nonresident citizens at reduced rates of 1 to 3% but ended the practice with the adoption of a new tax law in 1998.

The Soviet Union used to treat nonresident citizens as permanent tax residents, but after the country was dissolved in 1991, none of its successor states continued the practice.

Vietnam used to used to treat nonresident citizens as permanent tax residents but ended the practice in 2009.

We can easily see how global AeOI might make it possible to reverse this trend. If China was to adopt citizenship taxation and exert the same pressure as the US has with FATCA to achieve it, two very important countries would be stretching the residence definition beyond the OECD's global AEoI database. Bearing the extra costs and burdens of these extra measures would surely convince other countries to consider following suit.

That's why I think this would be a terrible idea. Fundamentally, taxing on the basis of citizenship is wrong from a normative point of view. But it is also a terrible idea for practical reasons. First, it's invasive (to say the least) to make access to basic bank accounts contingent on tracing bloodlines. Second, doing so globally, including forcing the world's poorest countries to play along, is a huge waste of administration resources by everyone. Third, creating global asset databases for tax exchange purposes creates massive security issues that have not been assessed in light of the fact that this will be done on the basis of nationality rather than residence. Finally, and in the long run, taxing on the basis of citizenship effectively restricts labour mobility, serving a goal I have not heard explained by anyone.

In a world in which state's tax subjects include their globally dispersed diasporas, global asset information exchange will make it a duty of every state to sort its population for differential treatment according to the birthright laws of the other states. This has never been an agenda item on any of the discussions I have seen regarding tax information exchange. It should be.

On the other hand, if other nations started doing it, it wouldn't take long for the US to cry "foul"! Right now the US only gets away with it because they're the only major nation doing it, and of course, they are the United States of Exceptionalism.

Allison, this article is being discussed over at Brock by both our Chinese and CBT experts. We could use your esteemed insight: http://isaacbrocksociety.ca/2015/01/08/no-china-does-not-have-citizenship-based-taxation/#comments

An excellent article Allison. Just to add that one of the (many) complications with citizenship-based taxation is that countries have different ways of determining who is a citizen and who not. For example, determining US citizenship can be quite easy; if you were born there, you're a citizen, regardless of whether or not you've ever lived there or had a US social security number or passport. In Germany, by comparison, as in most other European countries, citizenship is obtained by parentage, not by place of birth (with very limited exceptions). An involved application process is involved to prove you are entitled to German citizenship. In fact, recent changes to the law have excluded some from obtaining citizenship who previously would have qualified. The difficulty of determining something as basic as citizenship becomes quickly apparent. How can any financial institution anywhere possibly have the resources, as well as legal expertise, to deal with the nuances of citizenship for more than 200 countries in the world?

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